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Crude oil: Excess capacity

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Crude oil prices have plummeted since the start of the year, dropping 65% between January and April. Brent crude oil prices averaged $23/bbl in April, a multi-decade low. Demand for oil has collapsed as a result of shutdowns resulting from the coronavirus pandemic (COVID-19), which has sharply reduced transportation. The decline in prices was exacerbated by the breakdown of OPEC+ talks in early March, and a new production agreement announced on April 12 failed to boost prices. Prices recovered modestly during the first week of May as lockdown measures have started to be lifted in some countries, but they remain at very low levels.

Other benchmark prices have seen even more dramatic declines. On April 20, the WTI Cushing contract for delivery in May fell to nearly -$40/bbl. The magnitude of the collapse was due to both fundamentals—weak demand and limited storage capacity—and technical factors associated with the futures market. On the technical side, the drop reflected the fact that the May contract expired on April 21, and there was minimal storage capacity available for physical deliveries for the contract. Prices rebounded the following day, and the contract price for delivery in June (less immediately affected by these issues), did not see a decline of the same magnitude. But the drop nonetheless highlights the immense strain on the market.

The decrease in prices is due to a sharp fall in global consumption of crude oil. Mitigation measures to reduce the spread of COVID-19 have halted a large proportion of travel, with widespread flight cancellations, stay-at-home orders, and reduced global trade, all reducing demand for oil. For example, passenger journeys through Transportation Security Administration (TSA) checkpoints in the United States have fallen to around 5% of their 2019 level. The pandemic is also expected to have initiatied a deep global recession, further reducing oil demand.

Oil demand is set to plunge further in 2020Q2. U.S. gasoline demand declined by almost 50% in the first two weeks of April compared with the same period in 2019, while jet fuel is down by 60%. The International Energy Agency (IEA) projects that global oil demand will fall by 23% in 2020Q2, before gradually recovering as mitigation measures are lifted. For 2020 overall, global oil demand is expected to fall by nearly 10%, more than twice as large as any previous decline (in 1980).

Global oil production has been slower to fall than demand. Producers can be reluctant to close oil wells, even when prices fall below operating costs, as wells can be prohibitively costly to shut down and reopen. Also, the breakdown of the OPEC+ agreement in March triggered an end to their existing production cuts and led to Saudi Arabia announcing it intended to increase production in April to 12mb/d.

However, oil production is starting to fall. OPEC+ reached a new production agreement in April that included cuts of 9.7mb/d in May and June 2020, with Russia and Saudi Arabia each reducing production to 8.5mb/d, a sharp drop from existing levels. The groups’ cuts are set to reduce to 7.7mb/d from July 2020 to December 2020, and 5.8mb/d from January 2021 to April 2022. Among non-OPEC+ countries, most oil companies have implemented substantial cuts in capital expenditure. For example, the rig count in the United States has fallen by around 50% since March. Increasingly, producers are also announcing cuts in existing production. For example, Norway announced a reduction of 0.25 mb/d in June and 0.13 mb/d for the second half of 2020. The U.S. Energy Information Administration expects U.S. production to fall by just under 2mb/d from current levels to a low of 11mb/d in 2020Q4.

Outlook. Oil prices are projected to average $35/bbl in 2020 before recovering to $42/bbl in 2021, substantially lower than the October forecast of $58/bbl and $59/bbl. From their current lows, oil prices are expected to recover gradually in 2020 before strengthening into next year. The expected recovery is forecast to be one of the weakest in history following a major collapse in oil prices (i.e., compared with 2008, 1998, and 1986). The sharp downward revision to the forecast reflects the weakness in oil demand, which dominates any supply response, particularly in the short term. Prices are expected to rise in 2021 as mitigation measures lessen and demand recovers gradually, albeit to a lower level than previously expected. The substantial oil inventory overhang will likely cap any significant price increases over the year.

Risks. There are several risks to the forecast. They include a slower end to the pandemic that could lead to much lower demand than previously forecast, as well as a deeper recession than currently anticipated. Production could also be higher than expected, particularly if there is non-compliance with cuts among OPEC+ producers—during past rounds of production agreements, some countries exceeded their production quotas. To the upside, substantially weaker investment in new production, or permanent shutdown of some oil wells this year could reduce future production capacity, resulting in a sharper rebound in prices in 2021.


Peter Nagle

Senior Economist, Prospects Group

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